By David Sterman
Risk equals return. It's one of the most widely-held maxims in investing and, if you look at the numbers, the sentiment rings true. Stocks have returned about 9.5% a year since 1926, according to Ibbotson & Associates -- clearly better than the roughly 5.5% return bonds have delivered annually during that time. And bonds have surely beaten cash, which returns nothing.
Even within one asset class such as stocks, the maxim holds true -- the riskier the stock, the higher the potential return. That's surely the case if you look at the Fidelity Advisor Leveraged Company Stock Fund (FLSAX), the top-performing mutual fund in the diversified U.S. category in the past 10 years according to Morningstar, returning an annual average of 15%. The fund's secret: Embrace companies with plenty of debt, as their inherent riskiness leads many investors to shun them. As cash flow builds at these debt-laden firms, these companies can pay off debt, attracting investors that had shunned them previously and sending share prices higher.
Piggybacking with the pros
Fidelity's Tom Saviero has been running this fund since 2003, and though he's a bit chastened by the 2008 meltdown, he still prefers companies with ample debt loads. ON Semiconductor (ONNN), which is the fund's largest holding, is a perfect example. The company just completed a major acquisition of Sanyo's (OTC:SANYF) Japanese semiconductor business by adding to its debt load -- but the acquisition should sharply boost sales and profits for ON.
ON makes an incredibly wide range of chips that go into everything from mobile computing devices to cars. This is a semiconductor play on the broadening advances in technology, not just on one industry such as memory or microprocessors.
Sanyo, which operated three major fabrication plants in Japan, could never really achieve profits in the industry and wanted out. ON, eyeing the large Japanese market, wanted in. ON's management realized it could acquire all of the legacy products, shutter a great deal of Sanyo's manufacturing capacity, and ultimately generate much better margins than Sanyo could. As analysts at DA Davidson note:
Leveraging its scale, one of ON's competitive advantages has been the ability to successfully integrate strategic acquisitions of complementary semiconductor suppliers.
The Sanyo deal represents ON's 10th acquisition in the past 10 years, and is the second-largest, at $480 million, behind a $900 million purchase of AMIS Holdings in 2007. Much of the Sanyo deal is being paid for with a loan from Sanyo -- just the kind of debt leverage that the Fidelity Advisor Leveraged Company Stock Fund likes to see.
Analysts expect big things from the Sanyo deal, which could increase sales by 50%. Sanyo had operating margins below 2%, but ON thinks it can boost that figure to 10% in four to six quarters. If that happens, analysts think EPS (earnings per share) will jump from $1 this year to $1.30 in 2012. DA Davidson sees shares rising from $9.30 to $17, or 14 times its 2012 profit forecast. Needham thinks a multiple of 10 is more appropriate, and sees shares rising more modestly to $13.
A word of caution: The Japanese earthquake will hurt first quarter results, as ON has already discussed with analysts. But if the problems extend into the current quarter, then shares may stay range-bound until the acquired Sanyo operations are fully off the ground. This may explain why shares have slumped 20% in the past two months.
Housing would be a kicker
Operations at Owens-Corning (OC), another key holding of the Fidelity fund, are already humming along right now; with an eventual upturn in the housing market, this stock could really get going. About 2% of the fund is tied up in this company. Saviero likely appreciated this name for its balance sheet, which still carries more than $1.6 billion in debt, and because Owens Corning has become a profit machine, mostly on the back of its composites and roofing businesses. (Composites are any combination of materials that are joined together and are usually used to reinforce objects such as bathtubs or wind turbines.)
Owens Corning is the leading player in glass fiber composites (basically adulterated sand) that is a far cheaper option than exotic composites such as carbon fiber. The company has generated a cumulative $470 million in FCF (free cash flow) in the past two years, and analysts at Citigroup expect to see another $1 billion in FCF in the next three years.
Owens Corning is also a key player in roofing materials, and demand has held up fairly well, as existing homes eventually need new roofing tiles. When the housing market rebounds, demand for roofing materials should spike even higher; so should demand for Owens Corning's insulation materials. That division is operating at a small loss right now, but should become quite profitable when new housing construction trends turn back up.
Add it all up, and analysts at Citigroup see a great profit story. Per-share profits are expected to steadily rise from $1.57 in 2010 to $3.65 by 2013. All that cash flow? Well, it may not be used to pay down debt. Owens Corning likes to deploy debt leverage, which is fine with Fidelity's Saviero. Instead, Owens Corning may embark on a major stock buyback program, according to Citgroup's Josh Levin. He sees shares rising from $37 to $47 over the next year, or 8.7 times his projected 2011 EBITDA (earnings before interest, taxes, depreciation and amortization) estimate. Presumably, as he eventually sets his sights on 2012 and 2013 EBITDA projections, his target price will rise in tandem.
Fidelity's Saviero has to update his holdings every quarter. It pays to see which stocks he has recently started buying or which stocks he is adding to existing positions. As long as the economy remains aloft, his stock-picking prowess should continue to yield outsized returns.
As you might imagine, Saviero's is not a "rain or shine" approach. This kind of investing can be disastrous if the economy hits the skids and debt loads get really scary. The fund fell 54% in 2008. Yikes! Then again, even with that plunge, $10,000 invested in 2000 would be worth more than $40,000 today.
The fund's future performance is strictly a function of the economy. If you've got a dim view of the economy for the quarters and years ahead, then this fund is not for you. But if employment trends continue and GDP (gross domestic product) can climb nicely higher in coming years, this fund looks poised to continue outperforming many of its peers. An even savvier approach might be to glean individual picks that stand out, such as those I mentioned above. Based on Saviero's past performance, they could turn out to be real winners.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.